In our view, inflation is one of the biggest near-term risks facing investors today. Higher prices would prompt the Federal Reserve to ratchet up rates, and persistently higher interest yields would have the potential to undermine risk taking. This represents a potential headwind for both stock and bond investors.
Although when viewed through the lens of interest rates equities appear fairly priced, rates nowadays are arguably too low for current economic conditions thanks to overly generous central bank policies at home and abroad. Historically, the benchmark 10-year Treasury tracks nominal GDP growth, which is currently running at 4-5 per cent. Central bankers are emboldened by the absence of inflation, which is helping to support ongoing quantitative easing, particularly in Europe and Japan. Based on historical relationships, we would expect an 8-10 per cent decline in US equities should interest rates snap back to “fair value”.
In 1980, year-over-year core inflation reached a peak of 12.2%. Fortunately for central bankers and risk takers, inflation has been in secular decline for the last 38 years. But tranquil price growth has not always been the norm: during the 1965-80 period, year-over-year inflation rose 11 times, with the price index rising in five consecutive years from 1965 to 1970.
Since 1980, however, inflation has been in secular decline, and has not risen even three consecutive years during that time. For this we can give credit to a favorable blend of aggressive Federal Reserve policy, productivity, demographics and globalization. But we are concerned that the threat of a trade policy reversal could spur an inflationary trend. Globalization pushed production to the cheapest, most efficient destinations, notably China and the rest of the emerging world, where wages were a fraction of those in the North America and Europe and business regulations were non-existent. Nascent mercantilism, which would change the secular direction of globalization, has the potential to dampen productivity and spur inflation – neither of which would be good for stock or bond investors. Inflation remains quiescent for now, but we are on the lookout for incipient price pressure as an indicator that market tailwinds are shifting.